Is the Crowd Ready to Invest in Startups?

In 2012, Congress passed a piece of legislation known as the Jumpstart Our Small Businesses Act, better known as the JOBS Act. Among the provisions included in this law were instructions for the Securities and Exchange Commission to write rules that allow companies to seek investment from the public, similar to how individuals and nascent companies seek funding on popular crowdfunding sites like Kickstarter. This was a big step in how firms can seek capital from investors. The success of creative individuals funding projects via platforms like Kickstarter has stirred up hopes that the same kind of transformation can be made for young and small companies looking to grow Company growth requires some minimum level of capital, just as plants need soil to grow. Yet there is still uncertainty as to whether or not equity crowdfunding will prove to be anything more than a niche avenue filled with risk for firms that can’t solicit capital in traditional markets.

The difference between the donation crowdfunding that has existed and the equity crowdfunding this legislation intended to allow is investors would be able to contribute to companies and receive equity in the company, as opposed to just rewards based on their contribution level. Once the SEC wrote the rules that governed how this kind of investment could work, there was thought that equity crowdfunding could be a game-changing new addition to capital markets.

Since the passage of the JOBS Act, the SEC has spent nearly three years deliberating on how best to organize investment by the crowd. On October 30, 2015, the SEC commissioners came together and voted to approve the set of proposed rules for equity crowdfunding. While the rules are still proposed and won’t go into effect until at least early 2016, it is interesting to see how the SEC molded the regulations for this kind of investing.

The ever-present concern with crowdfunding, at all levels and designs, is the opportunity for fraud. Of the rules the SEC designed, laid out in their 500+ page document, many of them are aimed at limiting downside risks for both firms and investors. Crowdfunding is inherently risky, and it appears the SEC wrote rules that try to mitigate as much of that risk as possible.

Details of the New Rules

Some of the most important designations that the SEC made in their rules are:

Companies can solicit up to $1M in investment through the crowd. If the firm is seeking more than $500,000 through an online platform, the firm must provide audited financial statements.

Regardless of the amount the company is seeking, among the items that must be disclosed are how they’ll use the investment funding, a list of officers and directors at the company, and the names of any owners who own 20 percent or more of the company.

Firms wishing to sell equity to the crowd must do so either through a registered platform or a broker/dealer.

Individuals with incomes less than $100,000 may invest five percent of their income or $2,000, whichever is greater. Individuals with incomes over $100,000 can invest up to ten percent of their income.

No individual investor can invest more than $100,000 in any twelve month period.

Three Questions about the New Rules

These proposed rules are unsurprisingly strict, as the three year gap between the passage of the JOBS Act and the publishing of these rules symbolizes the hesitance of the SEC. This new avenue for firms to seek capital prompt a number of questions about how the process will work and who benefits most. There are three key questions that I think are most interesting to ask:

What Kind of Firms will Use Equity Crowdfunding?

Because firms can’t raise more than a million dollars (and are incentivized by the heavy financial auditing rules to raise $500,000, or even less), equity crowdfunding does not appear to be an option for firms looking for massive growth in a short period of time. But questions also arise on a broader level.

Will it be young firms (one or two years old) that will take advantage of this limited opportunity?

Will it be older firms, those who traditionally choose debt financing from banks as ways to raise money?

While SEC was deliberating, states took the initiative and passed intrastate crowdfunding exemption so firms could sell equity to in-state investors. A number of these firms were local companies, breweries, restaurants, and even musical instrument stores. Will the same trend continue for a national equity crowdfunding market?

Can Equity Crowdfunding Make a Dent as a Source of Financing?

With the rules the SEC has proposed, there are strict parameters as to how much investment firms can raise and how deeply investors can get involved. But will companies really see equity crowdfunding as a viable strategy? The majority of new firms use debt financing over equity, by a large margin, and banks are their primary source of financing. And debt financing does have some advantage over equity. Owners that choose debt financing maintain control of their business and don’t have to be beholden to the whims of equity-holders.

Equity crowdfunding also is designed to be attractive to investors. While some investors do invest with a social cause in mind, many more are concerned with the return on their investment. Will equity crowdfunding attract the quality of firms that make investing in another one a rational decision?

What Can Platforms Do?

The SEC rules promoted platforms as the preferred destination for crowdfunding. They gave platforms the power to curate which firms can be listed for crowdfunding, an important step that adds another layer of protection for investors. Because crowds that fund a company aren’t a legal group that can pursue legal action, it stands to reason that investors will lean on platforms to provide space for communication between investors, as well as between investors and firms.

A well-functioning communication portal would also amplify one of the best attributes of crowdfunding--the way founders can learn important market information from a large group. This may be especially relevant for equity crowdfunding. In states that allowed intrastate exemption, crowdfunders were sometimes loyal customers that wanted to support local businesses.

Equity crowdfunding still has a long way to go to prove it can be a significant source of financing for entrepreneurs. The pitfalls that have always been present did not disappear in the advent of the new SEC rules. But equity crowdfunding can provide capital for firms that have exhausted other options, and opportunity for individual investors to invest directly in startups, a market typically reserved for venture capitalists and angel investors. Investors and startups will be watching to see how the rules impact their businesses.

Chris Jackson is a research assistant in Research and Policy for the Ewing Marion Kauffman Foundation, assisting in the understanding of what policies and environments best promote entrepreneurship and education in the pursuit of economic growth.